Pre-GFC, IT services was a sector on the rise. Three companies, SMS (ASX:SMX), Oakton and UXC were valued by the market at more than half a billion dollars each, while new IPOs such as DWS (ASX:DWS) and CSG (ASX:CSV) traded at a significant premium to their listing price. With the wind at their backs, these companies had work thrown at them from all directions and couldn’t hire new staff quickly enough.
The post-GFC years haven’t been so kind. SMS is trading at a fraction of its all-time highs, following three changes of CEO in the last 18 months and several recent downgrades. In 2014 Oakton was taken over by multinational giant Dimension Data for a fraction of what it used to be worth. Earlier this year, UXC was taken over by U.S. behemoth CSC for less than its pre-GFC high. ASG (ASX:ASZ), DWS, and CSG are also trading well below 2007 levels.
So what went wrong? Was the pre-GFC period a peak in the cycle? Has the industry structurally changed? Or was there mismanagement across the board?
Certainly cyclical and structural changes have moved in tandem. When the business cycle turned up in 2003, IT services companies also benefited from the structural shift to outsourcing. It is no coincidence that most of them share Melbourne as their headquarters with Telstra, ANZ and Nab.
While lots of work is still outsourced, many clients have turned to large multinationals that can manage an entire project rather than several niche providers. Those multinationals have also become cheaper, thanks to the use of Indian IT companies with cheaper labour.
With structural change impacting the industry, some management and board vision would have come in handy. An industry-wide consolidation to create a major domestic force in IT services would have been able to compete with those multinationals. Most of these businesses, however, had one or two founding shareholders who didn’t want to let go of their babies.
So there have been missteps, and tailwinds have become headwinds. But the much larger issue is that these weren’t great businesses to begin with.
An observer in 2007 could be forgiven for thinking otherwise. Based on the pure financials, IT services companies looked like wonderful businesses. Their low capital requirements lead to balance sheets with little or no debt, high returns on capital and healthy cashflow generation. But those tailwinds mentioned previously were masking significant fragility.
Firstly, while these businesses might not require much financial capital, they are completely dependent on human capital that is not reflected on their balance sheets. And human capital can be fleeting. A further aspect of being a people business is that margins don’t benefit materially from getting bigger – if management wants to grow earnings, they need to grow staff numbers, which gives them little ability to increase margins. It could be argued that they suffer from cultural diseconomies of scale, due to higher administration costs associated with managing more staff and difficulties maintaining utilisation rates as they grow.
Secondly, there was nothing to stop competition increasing once the trend to outsourcing emerged. While IT services companies initially carved successful niches in the domestic market, these businesses proved to be little more than ‘body shops’. They have no IP and no sustainable competitive advantages. There was little to stop Indian companies tendering for work here or staff leaving to form their own small firms (and take clients with them).
Finally, earnings were very predictable on the way up, but highly unpredictable on the way down. Forecasting earnings was relatively straight forward when the businesses were growing – management would guide to increases in staff numbers with percentage increases in staff generally having a proportional impact on earnings increases. However, in recent years earnings have been very difficult to predict. Management teams have cut staff numbers in response to falling demand but this has not fixed poor utilisation as demand has fallen faster than expected, leading to earnings spiralling downward.
So where does this leave the listed IT services companies? Many have tried bolt-on acquisitions, share buy-backs and management changes to restore shareholder value. While these may stem the bleeding, the grand vision of industry-wide consolidation to create a tier one domestic IT services player remains elusive. Absent more takeovers by the global companies, the Aussie players seem destined to remain small with few competitive advantages.
Thanks Daniel the perspective and context you provide is insightful.
Out of curiosity have there been any domestic IT service businesses that have themselves outsourced to cheaper (Indian?) labour or established a JV to take advantage of this metric?
(Domestic company brings access & knowledge of local market along with reputation and Indian IT company provides cost effective capability)
Kind Regards Bruce.
Hi Bruce
Oakton set up an office in India and prior to de-listing in 2014 just over a quarter of their consultants were based there (just over 300 staff out of 1,200). As far as I’m aware, they were the only ASX-listed IT services company to do this in a meaningful way. However, the cost savings weren’t able to offset other headwinds impacting the business.
Daniel
I think there were two reasons for the flat growth of Australian IT services firms:
1. The IT services they offered more or less centered around technology, but not high end services, such as Information-based services and “as Service” offering.
2. They lacked the business SMEs and so failed to integrate their services with customer’s assets/capabilities.
I am an IT professional with 15 years of experience currently working for an IT service company. Here’s how I see the current Australian IT service landscape.
The majority of the customers of the IT sector in Australia is dominated by a very few large corporations: Telstra and big banks. Since GFC the focus of those corporations was on cost cutting, hence lower IT spending. However, they still have projects which require investment in IT, and their customers demand new mobile apps, more convenient web sites, etc. Therefore, although they can’t eliminate their IT spending altogether, they increasingly opt for cheaper options.
Sadly, the IT services have mostly become a commodity. The value proposition in IT is very hard to come by, so they mostly compete on price. And that’s how the large multinationals with extensive workforce in India win – by aggressively competing on prices. They win more tenders, as a result they have more projects in their portfolio, which creates more experience for them to brag about, which leads to more tenter so won. That creates a virtuous cycle. Other IT companies without an extensive offshore base can’t compete on prices due to high cost of Australian labour, and they lose.
On the side note, I reckon that the offshore multinationals win on prices only because they bid aggressively, and they win the wallets of the executives who are focused on the short term. Because the “cheap offshore labour” is more expensive in the long term. I’ve seen it over and over again. The quality of what the offshore guys do just isn’t high enough, and almost always it leads to huge delays, cost overruns and future reworks. But by the time the botched IT project comes back to roost, the exec who approved it is long moved on with a huge bonus for “saved” cost.